We live in a time where the proliferation of business news arguably exposes economic data and business leaders to unprecedented scrutiny. We also recognize that investor preferences and biases are influenced by market experiences. Consider that during the last 10 years, we have had two dramatic bear markets. In our view, today's combination of information overload and challenging investment experiences is contributing greatly to the high level of risk aversion currently displayed by investors (both institutional and retail) as evidenced by record capital flows into bonds and bond funds. 1
This reality has resulted in some of the most dramatic, short-term, equity price volatility since the Great Depression as investors wrestle with the need to preserve capital in the short term, while positioning their portfolios for long-term success. 2
In addition to ongoing macro-economic and political conditions, we believe a number of factors are exacerbating volatility:
- The global integration of trade and financial markets. This trend is producing highly interdependent markets. Correlation among global markets is at multi-decade highs and so, for example, when the U.S. housing and credit bubble collapsed, markets worldwide felt the effects. 3
- The ongoing growth of exchange-traded funds. Such funds involve investors trading baskets of stocks as a means of avoiding stock-specific risk. As a result, groups of stocks are moving up and down together, despite their respective business fundamentals. 4
- The rise of electronically programmed trading. Computers are increasingly trading among themselves as progressively more sophisticated programs are devised to exploit tiny market inefficiencies. Such trading techniques have a time horizon of under a second and "account for about 60% of the seven billion shares that change hands daily on United States stock markets." 5 This type of trading is also prevalent in fixed income and futures markets.
Though not immune to the vagaries of the market, as active managers, our disciplined approach to identifying opportunities is not rattled by short-term volatility. In fact, heightened volatility can create more opportunity for finding attractive entry points to targeted stocks.
Dimming The Noise
As investors are bombarded with daily reports on market gyrations, we think it is worth noting that for all the noise and angst such fluctuations are not generally influencing the longer-term volatility of stock markets. For example, looking at the rolling 10-year standard deviation of monthly, quarterly and annual changes in the Dow Jones Industrial Average, we see equity market price volatility is in line with levels seen throughout the postwar era. 6 Also, while the number of 5% and 10% market pullbacks has increased in recent years, they are consistent with levels seen in the 1970s and early 1980s when the market consolidated over a multi-year period. 7 Though the sky may appear to be falling, based on facts and our experience, we think prudent investors should remain focused on their long-term plans.
Over the last 10 years, investors have not been rewarded for taking on stock market risk. In general, bonds have outperformed equities and have had a much lower volatility profile. 8 However, going forward, we believe equities will likely revert to longer-term average returns as issues related to the debt and deleveraging of developed economies are hopefully resolved and emerging markets begin a transition to a more consumer-led focus, which should drive global demand growth. Unfortunately, as in the past, such transition periods are marked by heightened volatility that challenges the resolve of even the most patient investor. We believe long-term investment success continues to be determined by a focus on investment fundamentals according to the risk tolerance of each investor.
The above Index reviews are calculated from external sources and, where applicable, reflect total returns.
All figures are in Canadian dollars and are as of December 31, 2011.
(1) Dow Jones, "Credit Markets; Treasurys Up, Corporate Funds See Best In Flow," The Wall Street, December 20, 2011.
(2) Wells Capital Management, "Economic and Market Update," November 14, 2011.
(3) RBC Capital Market, "U.S. Equity Strategy Weekly," Industry/Comment, December 14, 2011.
(5) "High-Frequency Trading," The New York Times, nytimes.com/topics, updated October 10, 2011.
(6) Wells Capital Management, "Economic and Market Update," November 14, 2011.
(7) Hesperian Capital Management Ltd., "The nature of market corrections and how they impact Norrep's investment philosophy."
(8) FactSet, January 2011.